Tutorial 5: The Theory of Consumer Choice

Exercise 1:
a) Since the price of coffee rises, her budget constraint pivots inwards from BC1 to BC2.

b) If the substitution effect outweighs the income effect for croissants, Jennifer buys more croissants
and less coffee. She moves from point A to point B.
c) If the income effect outweighs the substitution effect for croissants, Jennifer buys fewer
croissants and less coffee, moving from point A to point B.

Exercise 2:
a) MRS can be defined as how many units of good x have to be given up in order to gain an extra
unit of good y, while keeping the same level of utility. Or the rate at which a person will exchange
a good Y by a good X. In the optimum MRS = ∂Ux/∂Uy =Px/Py.
b) In this example we use the optimization by substitution.
U(X,Y ) = √X + √Y
I=X+3Y
MRS =∂Ux/∂Uy=1/3
(2) in (1)=>1 = X + 3 (1/9 x) => x = ¾ I (3)
(3) in (2) => Y=13/12 I
c) Substitute the values for the two prices and income into the demand functions to find that she
consumes X=75 candy bars and Y=8.3 espressos.

Exercise 3 :
Φ=20X+80Y-X2-2Y2 - 2(X+2Y-41).
To find the optimal consumption of each good, we need to maximize the Lagrangian equation with
respect to X, Y, and 2, which is the same as maximizing utility subject to the budget constraint. The
necessary conditions for a maximum are

1-∂ф/∂X=20-2X-λ =0

2-∂ф/∂X= 80-4Y-2λ =0

3--∂ф/∂X= X+2Y-41 =0
Combining necessary conditions (1) and (2) results in
λ=20-2X=40-2Y
(4) 2Y=20+2X.
The optimal bundle is X=7 and Y=17.